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It is hard to find any good economic arguments for protectionism. Economists have known this at least since Adam Smith wrote the Wealth of Nations in 1776. That, however, has not stopped president-elect Donald Trump putting forward his protectionist agenda.

At the core of Trump’s protectionist thinking is the idea that trade is essentially a zero sum game. Contrary to conventional economic thinking, which sees trade as mutual beneficial Trump talks about trade in terms of winners and losers. This means that Trump essentially has a Mercantilist ideology, where the wealth of a nation can be measured on how much the country exports relative to its imports.

Therefore, we should expect the Trump administration to pay particularly attention to the US trade deficit and if the trade deficit grows Trump is likely to blame countries like Mexico and China for that.

The Yellen-Trump policy mix will cause the trade deficit to balloon

The paradox is that Trump’s own policies – particularly the announced major tax cuts and large government infrastructure investments – combined with the Federal Reserve’s likely response to the fiscal expansion (higher interest rates) in itself is likely to cause the US trade deficit to balloon.

Hence, a fiscal expansion will cause domestic demand to pick up, which in turn will increase imports. Furthermore, we have already seen the dollar rally on the back of the election Donald Trump as markets are pricing in more aggressive interest rate hikes from the Federal Reserve to curb the “Trumpflationary” pressures.

The strengthening of the dollar will further erode US competitiveness and further add to the worsening the US trade balance.

Add to that, that the strengthen of the dollar and the fears of US protectionist policies already have caused most Emerging Markets currencies – including the Chinese renminbi and the Mexican peso – to weaken against the US dollar.

The perfect excuse

Donald Trump has already said he wants the US Treasury Department to brand China a currency manipulator because he believes that China is keeping the renminbi artificial weak against the dollar to gain an “unfair” trade advantage against the US.

And soon he will have the “evidence” – the US trade deficit is ballooning, Chinese exports to the US are picking up steam and the renminbi continues to weaken. However, any economist would of course know that, that is not a result of China’s currency policies, but rather a direct consequence of Trumponomics more specifically the planed fiscal expansion, but Trump is unlikely to listen to that.

There is a clear echo from the 1980s here. Reagan’s tax cuts and the increase in military spending also caused a ‘double deficit’ – a larger budget deficit and a ballooning trade deficit and even though Reagan was certainly not a protectionist in the same way as Trump is he nonetheless bowed to domestic political pressures and to the pressures American exporters and during his time in offices and numerous import quotas and tariffs were implemented mainly to curb US imports from Japan. Unfortunately, it looks like Trump is very eager to copies these failed policies.

Finally, it should be noted that in 1985 we got the so-called Plaza Accord, which essentially forced the Japanese to allow the yen to strengthen dramatically (and the dollar to weaken). The Plaza Accord undoubtedly was a contributing factor to Japan’s deflationary crisis, which essentially have lasted to this day. One can only fear that a new Plaza Accord, which will strengthen the renminbi and cause the Chinese economy to fall into crisis is Trump’s wet dream.

Hong Kong banks do not rely on Hibor to anywhere near the same degree that global banks rely on Libor, the more famous US-dollar counterpart that is a crucial benchmark for loans that global lenders rely on for trillions of dollars of funding each day.

As such, the spike in CNH-Hibor has little practical impact on the banks themselves, but it has recently been viewed as more of a deterrent to speculators betting on CNH, the offshore renminbi.

On January 12, CNH-Hibor hit 66.815 per cent, the highest level since the benchmark was introduced in 2013, amid heavy speculation the People’s Bank of China, acting through state-owned banks, was soaking up liquidity to make the cost of shorting the renminbi more prohibitive as the currency came under pressure from speculators.

Ahead of this month’s G20 summit Commerzbank analyst Hao Zhou was among those predicting the PBoC would hold the line at Rmb6.7 against the dollar for a number of reasons, including a desire to facilitate special drawing rights (SDR) operations set to begin on October 1. However, he noted that “of course, politics tops the agenda again, especially as China is keen to show its ability to manage the whole economy and financial markets although the country still faces strong capital outflows.”

The central bank today weakened the currency’s midpoint fix for the first time since the end of G20, a move in line with analyst predictions that efforts to shore up the renminbi’s value would dissipate when the summit was over.

A spike in Hibor would track with a scenario in which the central bank either intervened itself or had mainland banks sop up liquidity on its behalf. It also has other options – as Commerzbank’s Zhou noted late last month: “We also expect that China’s central bank will allow the local banks to trade CNH in September, in order to narrow the CNY-CNH spread.”

As my loyal readers know I am very critical about this deal (see my post on that topic here) as I believe that it is an attempt to quasi fix global exchange rates to avoid ‘currency war’ effectively limits the possibility for monetary easing – both in the US and China.

Ending China’s crawling devaluation will be bad news

Since the Federal Reserve in December hiked the fed funds target rate the People Bank of China effective has tried to decouple Chinese monetary policy from US monetary policy by allowing a crawling devaluation of the Renminbi.

This in my view has played a positive role in offsetting the negative impact of the Fed’s foolish attempt to tighten US monetary conditions.

However, the Sino-US ‘currency peace’ deal limits the PBoC’s possibility of continuing this policy and this is why HIBOR rates are now surging. This obviously is bad news for the Chinese economy – in fact it is bad news for the global economy and markets.

China does not need tighter monetary conditions. Chinese monetary conditions in my view is still quasi-deflationary and if the PBoC abandons its unannounced crawling devaluation policy it will cause a excessive tightening of Chinese monetary conditions, which could push back the Chinese economy towards recession.

It is too bad that policy makers from the ‘Global Monetary Superpowers’ believe that limiting currency flexibility is the right policy. Instead they should embrace floating exchange rates and instead focus on avoiding the biggest risk to the global economy – deflation.

China’s central bank conducted the biggest reverse-repurchase operations since September, adding funds to the financial system after money-market rates surged and equities slumped.

The People’s Bank of China offered 130 billion yuan ($19.9 billion) of seven-day reverse repos on Tuesday at an interest rate of 2.25 percent. The monetary authority suspended the operations in the last auction window on Dec. 31, ending a six-month run of cash injections that helped drive borrowing costs lower in an economy estimated to grow at the slowest pace in more than two decades.

The People’s Bank of China (PBoC) continues to behave as if there is not Tinbergen constraint, but the PBoC soon has to realize it cannot continue to try to ease monetary conditions through liquidity injects into the money markets, lowering of reserve requirements and cutting interest rates, while at the same time trying to maintain an artificially strong Renminbi.

What the PBoC effectively is doing it trying to ease monetary policy with the one hand, while at the same time tightening monetary policy with the other hand by intervening in the currency market to prop up the Renminbi.

Instead it is about time that PBoC either let the Renminbi float completely freely (which effectively would cause a significant depreciation of RMB) or implement a large devaluation – for example 30% – so to avoid any speculation of further devaluations and then introduce a peg to a basket of currency as hinted in December.

The problem with the present policy is that everybody in the market realizes that this is what we will get eventually and that has caused an escalation of the currency outflow from China and this outflow is likely to continue until the PBoC bites the bullet and introduce a completely new monetary regime. This halfway house will not stand for long and if the PBoC keeps fighting it the central bank will just do even more harm to the Chinese economy and potentially also cause an major banking crisis.

PBoC is not alone in making this mistake and the Tyranny of the Status Que is strong within central banks around the world. Two good example are Kazakhstan and Azerbaijan. Both countries have in recent months given up the tighten link to the US Dollar and devalued their currencies significantly. This in my view has been the right decision as both of these oil exporting countries have been suffering significantly from the continued decline in oil prices.

But neither the Kazakhstani nor the Azerbaijani central banks (and governments) have introduce new rule based monetary policy regimes. So one can say they have left the Dollar peg, but forgot to finish the job. Therefore policy makers in both countries should now focus on what regime should replace the Dollar peg. I would recommend an Export Price Norm for both countries, where their currencies are pegged to a basket of the oil prices and the currencies of the countries’ main trading partners.

And China need to do the same thing – not introducing an Export Price Norm, but rather let the Renminbi float and then introduce an NGDP target or a nominal wage growth target and it need to do it very soon to avoid an escalation of the financial distress.

The PBoC has the power to end this crisis right now by floating the Renminbi, but the longer this decision is postponed the bigger the risk of something blowing up becomes.

PS notice that despite the sharp rise in tensions between Saudi Arabia and Iran oil prices are now lower than on at the close of trading last week. That to me is a pretty strong indication just how worried that markets are about China.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

I have for sometime argued that the quasi-currency union ‘Dollar Bloc’ is not an Optimal Currency Area and that it therefore is doomed to fall apart.

The latest ‘member’ of the ‘Dollar Bloc’ left today. This is from Bloomberg:

Azerbaijan’s manat plunged to the weakest on record after the central bank relinquished control of its exchange rate, the latest crude producer to abandon a currency peg as oil prices slumped to the lowest in 11 years.

The third-biggest oil producer in the former Soviet Union moved to a free float on Monday to buttress the country’s foreign-exchange reserves and improve competitiveness amid “intensifying external economic shocks,” the central bank said in a statement. The manat, which has fallen in only one of the past 12 years, nosedived 32 percent to 1.5375 to the dollar as of 2:30 p.m. in the capital, Baku, according to data compiled by Bloomberg.

The Caspian Sea country joins a host of developing nations from Vietnam to Nigeria that have weakened their currencies this year after China devalued the yuan, commodities prices sank and the Federal Reserve prepared to raise interest rates. Azerbaijan burned through more than half of its central bank reserves to defend the manat after it was allowed to weaken about 25 percent in February as the aftershocks of the economic crisis in Russia rippled through former Kremlin satellites.

The list of de-peggers from the dollar grows longer by the day – Kazakhstan, Armenia, Angola and South Sudan (the list is longer…) have all devalued in recent months as have of course most importantly China.

It is the tribble-whammy of a stronger dollar (tighter US monetary conditions), lower oil prices and the Chinese de-coupling from the dollar, which is putting pressure on the oil exporting dollar peggers. Add to that many (most?) are struggling with serious structural problems and weak institutions.

This process will likely continue in the coming year and I find it harder and harder to believe that there will be any oil exporting countries that are pegged to the dollar in 12 months – at least not on the same strong level as today.

De-pegging from the dollar obviously is the right policy for commodity exporters given the structural slowdown in China, a strong dollar and the fact that most commodity exporters are out of sync with the US economy.

Therefore, commodity exporters should either float their currencies and implement some form of nominal GDP or nominal wage targeting or alternatively peg their currencies at a (much) weaker level against a basket of oil prices and other currencies reflecting these countries trading partners. This of course is what I have termed an Export Price Norm.

Unfortunately, most oil exporting countries seem completely unprepared for the collapse of the dollar bloc, but they could start reading here or drop me a mail (lacsen@gmail.com):

If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

When you read the standard macroeconomic textbook you will be introduced to different macroeconomic models and the characteristics of these models are often described as keynesian and classical/monetarist. In the textbook version it is said that keynesians believe that prices and wages are rigid, while monetarist/classical economist believe wages and prices are fully flexible. This really is nonsense – monetarist economists do NOT argue that prices are fully flexible neither did pre-keynesian classical economists. As a result the textbook dictum between different schools is wrong.

I would instead argue that the key element in understanding the different “scenarios” we talk about in the textbook is differences in monetary regimes. Hence, in my view there are certain monetary policy rules that would make the world look “keynesian”, while other monetary policy rules would make the world look “classical”. As I have stated earlier – No ‘General Theory’ should ignore the monetary policy rule.

The standard example is fixed exchange rates versus floating exchange rates regimes. In a fixed exchange rate regime – with rigid prices and wages – the central bank will use monetary policy to ensure a fixed exchange and hence will not offset any shocks to aggregate demand. As a result a tightening of fiscal policy will cause aggregate demand to drop. This would make the world look “keynesian”.

On the other hand under a floating exchange rate regime with for example inflation targeting (or NGDP targeting) a tightening of fiscal policy will initially cause a drop in aggregate demand, which will cause a drop in inflation expectations, but as the central bank is targeting a fixed rate of inflation it will ease monetary policy to offset the fiscal tightening. This mean that the world becomes “classical”.

We here see that it is not really about price rigidities, but rather about the monetary regime. This also means that when we discuss fiscal multipliers – whether or not fiscal policy has an impact on aggregate demand – it is crucial to understand what monetary policy rule we have.

In this regard it is also very important to understand that the monetary policy rule is not necessarily credible and that markets’ expectations about the monetary policy rule can change over time as a result of the actions and communication of the central and that that will cause the ‘functioning’ the economy to change. Hence, we can imagine that one day the economy is “classical” (and stable) and the next day the economy becomes “keynesian” (and unstable).

Yellen is a keynesian – unfortunately

I fear that what is happening right now in the US economy is that we are moving from a “classical” world – where the Federal Reserve was following a fairly well-defined rule (the Bernanke-Evans rule) and was using a fairly well-defined (though not optimal) monetary policy instrument (money base control) – and to a much less rule based monetary policy regime where first of all the target for monetary policy is changing and equally important that the Fed’s monetary policy instrument is changing.

When I listen to Janet Yellen speak it leaves me with the impression of a 1970s style keynesian who strongly believes that inflation is not a monetary phenomena, but rather is a result of a Phillips curve relationship where lower unemployment will cause wage inflation, which in turn will cause price inflation.

It is also clear that Yellen is extraordinarily uncomfortable about thinking about monetary policy in terms of money creation (money base control) and only think of monetary policy in terms of controlling the interest rate. And finally Yellen is essentially telling us that she (and the Fed) are better at forecasting than the markets as she continues to downplay in the importance of the fact that inflation expectations have dropped markedly recently.

This is very different from the views of Ben Bernanke who at least at the end of his term as Fed chairman left the impression that he was conducting monetary policy within a fairly well-defined framework, which included a clear commitment to offset shocks to aggregate demand. As a result the Bernanke ensured that the US economy – like during the Great Moderation – basically became “classical”. That was best illustrated during the “fiscal cliff”-episode in 2013 where major fiscal tightening did not cause the contraction in the US economy forecasted by keynesians like Paul Krugman.

However, as a result of Yellen’s much less rule based approach to monetary policy I am beginning to think that if we where to have a fiscal cliff style event today (it could for example be a Chinese meltdown) then the outcome would be a lot less benign than in 2011.

How a negative shock would play with Yellen in charge of the Fed

Imagine that the situation in China continues to deteriorate and develop into a significant downturn for the Chinese economy. How should we expect the Yellen-fed to react? First of all a “China shock” would be visible in lower market inflation expectations. However, Yellen would likely ignore that.

She has already told us she doesn’t really trust the market to tell us about future inflation. Instead Yellen would focus on the US labour market and since the labour market is a notoriously lagging indicator the labour market would tell her that everything is fine – even after the shock hit. As a result she would likely not move in terms of monetary policy before the shock would show up in the unemployment data.

Furthermore, Yellen would also be a lot less willing than Bernanke was to use money base control as the monetary policy instrument and rather use the interest rate as the monetary policy instrument. Given the fact that we are presently basically stuck at the Zero Lower Bound Yellen would likely conclude that she really couldn’t do much about the shock and instead argue that fiscal policy should be use to offset the “China shock”.

All this means that we now have introduced a new “rigidity” in the US economy. It is a “rigidity” in the Fed monetary policy rule, which means that monetary policy will not offset negative shocks to US aggregate demand.

If the market realizes this – and I believe that is actually what might be happening right now – then the financial markets might not work as the stabilizing factoring in the US economy that it was in 2013 during the fiscal cliff-event and as a result the US economy is becoming more “keynesian” and therefore also a less stable US economy.

Only a 50% keynesian economy

However, Yellen’s economy is only a 50% keynesian economy. Hence, imagine instead of a negative “China shock” we had a major easing of US fiscal policy, which would cause US aggregate demand to pick up sharply. Once that would cause US unemployment to drop Yellen would move to hike interest rates. Obviously the markets would realize this once the fiscal easing would be announced and as a result the pick up in aggregate demand would be offset by the expected monetary tightening, which would be visible in a stronger dollar, a flattening of the yield curve and a drop in equity prices.

In that sense the fiscal multiplier would be zero when fiscal policy is eased, but it would be positive when fiscal policy is tightened.

What Yellen should do

I am concerned that Yellen’s old-school keynesian approach to monetary policy – adaptive expectations, the Phillips curve and reliance of interest rates as a policy instrument – is introducing a lot more instability in the US economy and might move us away from the nominal stability that Bernanke (finally) was able to ensure towards the end of his terms as Fed chairman.

But it don’t have to be like that. Here is what I would recommend that Yellen should do:

Introduce a clear target for monetary policy

Since Mid-2009 US nominal GDP has grown along a nearly straight 4% path (see here). Yellen should make that official policy as this likely also would ensure inflation close to 2% and overall stable demand growth, which would mean that shocks to aggregate demand “automatically” would be offset. It would so to speak make the US economy “classical” and stable.

Make monetary policy forward-looking

Instead of focusing on labour conditions and a backward-looking Phillips curve Yellen should focus on forward-looking indicators. The best thing would obviously be to look at market indicators for nominal GDP growth, but as we do not have those at least the Fed should focus on market expectations for inflation combined with surveys of future nominal GDP growth. The Fed should completely give up making its own forecasts and particularly the idea that FOMC members are making forecasts for the US economy seems to be counter-productive (today FOMC members make up their minds about what they want to do and then make a forecast to fit that decision).

Forget about interest rates – monetary policy is about money base control

With interest rates essentially stuck at the Zero Lower Bound it becomes impossible to ease monetary policy by using the interest rate “instrument”. In fact interest rates can never really be an “instrument”. It can be a way of communicating, but the actual monetary policy instrument will alway be the money base, which is under the full control of the Federal Reserve. It is about time that the Fed stop talking about money base control in discretionary terms (as QE1, QE2 etc.) and instead start to talk about setting a target for money base growth to hit the ultimate target of monetary policy (4% NGDP level targeting) and let interest rates be fully market determined.

I am not optimistic that the Fed is likely to move in this direction anytime soon and rather I fear that monetary policy is set to become even more discretionary and that the downside risks to the US economy has increased as Yellen’s communication is making it less likely that the markets will trust her to offset negative shocks to the US economy. The Keynesians got what they asked for – a keynesian economy.

PPS I would also blame Stanley Fischer – who I regret to say thought would make a good Fed chairman – for a lot of what is happening right now. While Stanley Fischer was the governor of the Bank of Israel he was essentially a NGDP targeting central banker, but now he seems preoccupied with “macroprudential” analysis, which is causing him to advocate monetary tightening at a time where the US economy does not need it.

PPPS I realize that my characterization of Janet Yellen partly is a caricature, but relative to Ben Bernanke and in terms of what this means for market expectations I believe the characterization is fair.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: roz@specialistspeakers.com. For US readers note that I will be “touring” the US in the end of October.

It is becoming increasingly clear that the Chinese authorities are mismanaging the economic and financial situation and the risk that the authorities will to cause something to blow increases day by day.

First we had the ill-advised attempts to prop up the falling Chinese stock market by the Chinese authorities essentially buying stocks and by to some extent banning the selling of stocks.

Among the arrested is Wang Xiaolu, a journalist for financial publication Caijing Magazine, “who has been placed under ‘criminal compulsory measures’ for suspected violations of colluding with others and fabricating and spreading fake information on securities and futures market,” according to Chinese state media.

This smells of desperation and signals to global investors that the Chinese authorities really are clueless about what is going on in the economy and in the markets.

Obviously the Chinese stock markets are not falling because of “rumours”, but this is the well-known behavior of many governments around the world – when the markets are going up it is because of the great policies of the government, but when they are going down it is because of the evil actions of “speculators”.

Meanwhile the Chinese authorities are continuing to claim that everything is fine and that real GDP is growing above 7%. However, looking at all other indicators of Chinese growth it is clear that the Chinese economy is slowing fast and is growing much less than 7%.

Just take two sets of data published today. First of all, the final Caixin/Markit manufacturing purchasing managers’ index (PMI) dropped to 47.3 in August – the lowest reading since March 2009 and down from 47.8 in July.

Second and equally telling South Korean exports dropped as much as 14.7% y/y in August – much more than the consensus expectation of a 5.9% y/y drop. China of course is a key market for South Korean exports and South Korean export normally is a very good indicator of Chinese manufactoring activity.

Given the kind of drop in the Chinese stock markets we have seen in August and what the commodity markets are telling us and given the macroeconomic data coming out it is pretty hard to avoid the conclusion that China was hit by a “sudden stop” in August as we saw a serious escalation of the currency and capital outflows.

This is of course also what we have been seeing in the currency markets, where the Chinese authorities have been forced to allow the renminbi to weaken. The forward markets are telling us that more devaluations should be expected.

To make things worse we today got yet another policy failure when the People’s Bank of China (PBoC) in yet another attempt to make the problems go away announced that it will try to limit capital outflows by imposing a reserve requirement on financial institutions trading in foreign-exchange forwards for clients. This is essentially a form of currency controls.

This is of course just another attempt of trying to shoot the messenger. The markets are telling us that more devaluations are coming. How do you manage that problem? Shot down the market. Again this smells of panic and the likely consequence is to further escalate the outflows rather than the opposite.

But it not only smells of panic – it also is doing a lot of harm to the Chinese economy. Maybe paradoxically the small stepwise devaluations of the renminbi have signaled to the markets that more devaluations are coming and as a result this has escalated currency and capital outflows.

As a result the PBoC has had to do even more intervention in the currency markets to prop up the renminbi. This of course is essentially monetary tightening and the consequence will be a further slowdown of the Chinese economy and likely also more financial distress.

Let the RMB float!

This is also an important lessons to other “peggers”. There is no such thing as a small devaluation. Either you maintain your peg or you let you currency float.

So to me there is really only one way out of this problem for the Chinese authorities – stop the shenanigans and let the renminbi float freely!

This likely would lead to a major drop in the Chinese currency in the near-term, but the alternative is that the outflows continues and if the PBoC continues to intervene and continues to introduce draconian anti-market measures (such as jailing journalists and banding FX and equity selling) and then the crisis will just deepen.

The developments in the past few weeks have reminded us all that China really still very much is an Emerging Markets and that the Chinese authorities are much less in control of events than many people believed.

The Chinese authorities had it easy as long as the structural tailwinds kept the capital flows coming in and the US kept monetary policy easy. However, now we are seeing a sharp structural slowdown in the Chinese economy, currency outflows and an effective tightening of US monetary conditions. As a consequence it is becoming more and more evident that the Chinese authorities are not the supermen that they sometimes have been made up to be.

As I argued in my previous blog post this is essentially the ‘dollar bloc’, which is falling apart. If the Chinese authorities continues to try to fight the inevitable – a fairly large renminbi depreciation – then a lot more harm will be done to the Chinese economy and the risk of full-scale financial crisis increases dramatically.

We have it all here – monetary strangulation through a badly constructed monetary regime, political mismanagement and when the story of this crisis will be written I don’t doubt there will be lots of talk of moral hazard and cronyism as well. In fact when I watch the actions of the Chinese authorities I am reminded of the way the Suharto regime in Indonesia (mis)handled the crisis in 1997-98.

It was the same finger-pointing at “evil speculators” and the introduction of draconian and ill-advised methods to prop up the currency. In the end it all failed – the central bank was forced to allow a major devaluation, but only after an ill-fated attempt to prop up the currency more or less had blown up the financial system and caused a major contraction in the economy. And it was of course also an end of the Suharto regime (probably the most positive effect of the crisis).

The Chinese Communist party today should remember how and why Suharto’s regime fell apart. China can still avoid a Indonesian style crisis, but then the Chinese authorities should stop copying Suharto’s policies.

Global stock markets are in a 2008ish kind of crash today and I really don’t have much time to write this, but I just want to share my take on it.

To me this is fundamentally about the in-optimal currency union between the US and China. From 1995 until 2005 the Chinese renminbi was more or less completely pegged to the US dollar and then from 2005 until recently the People’s Bank of China implemented a gradual managed appreciation of the RMB against the dollar.

This was going well as long as supply side factors – the opening of the Chinese economy and the catching up process – helped Chinese growth.

Hence, China went through one long continues positive supply shock that lasted from the mid-1990s and until 2006 when Chinese trend growth started to slow. With a pegged exchange rate a positive supply causes a real appreciation of the currency. However, as RMB has been (quasi)pegged to the dollar this appreciation had to happen through domestic monetary easing and higher inflation and higher nominal GDP growth. This process was accelerated when China joined WTO in 2001.

As a consequence of the dollar peg and the long, gradual positive supply shock Chinese nominal GDP growth accelerated dramatically from 2000 until 2008.

However, underlying something was happening – Chinese trend growth was slowing due to negative supply side headwinds primarily less catch-up potential and the beginning impact of negative labour force growth and the financial markets have long ago realized that Chinese potential growth is going to slow rather dramatically in the coming decades.

As a consequence the potential for real appreciation of the renminbi is much smaller. In fact there might be good arguments for real depreciation as Chinese growth is fast falling below trend growth, while trend itself is slowing.

With an quasi-pegged exchange rate like the renminbi real depreciation will have to happen through lower inflation – hence through monetary tightening. And this I believe is part of what we have been seeing in the last 2-3 years.

The US and China is not an optimal currency area and therefore the renminbi should of course not be pegged to the dollar. That was a problem when monetary conditions became excessively easy in China ahead of 2008 (and that is a big part of the commodity boom in that period), but it is an even bigger problem now when China is facing structural headwinds.

Yellen was the trigger

Hence, the underlying cause of the sell-off we have seen recently in the Chinese and global stock markets really is a result of the fact that the US and China is not an optimal currency area and as Chinese trend growth is slowing monetary conditions is automatically tightened in China due to the quasi-peg against the dollar.

This of course is being made a lot worse by the fact that the Fed for some time has become increasingly hawkish, which as caused an strong appreciation of the dollar – and due to the quasi-peg also of the renminbi. And worse still – in July Fed chair Janet Yellen signaled that the Fed would likely hike the Fed funds rate in September. This to me was the trigger of the latest round of turmoil, but the origin of the problem is a structural slowdown in China and the fact China is not an optimal currency area.

China should de-peg and Yellen should postpone rate hikes

Obviously the Chinese authorities would love the Fed to postpone rate hikes or even ease monetary policy. This would clearly ease the pressures on the Chinese economy and markets, but it is also clear that the Fed of course should not conduct monetary policy for China.

So in the same way that it is a problem the Germany and Greece are in a monetary union together it is a problem that China and the US are in a quasi-currency union. Therefore, the Chinese should of course give up the dollar peg and let the renminbi float freely and my guess is that will be the outcome in the end. The only question is whether the Chinese authorities will blow up something on the way or not.

Finally, it is now also very clear that this is a global negative demand shock and this is having negative ramifications for US demand growth – this is clearly visible in today’s stock market crash, massively lower inflation expectations and the collapse of commodity prices. The Fed should ease rather than tighten monetary policy and the same goes for the ECB by the way. If the ECB and Fed fail to realize this then the risk of a 2008 style event increases dramatically.

We should remember today as the day where the ‘dollar bloc’ fell apart.

If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

And while we are talking about the euro here is an op-ed of mine from the Danish newspaper Jyllandsposten on the same topic (in Danish).

Then something completely different – here I am telling Berlingske Business the story of my Great-great grandfather Sven Perssonwho emigrated to Denmark from Sweden in 1880 and hence contributed to the economic development in both countries. I make the case for completely Open Borders and argues that that we could double global GDP if we removed all anti-immigration regulation globally. See my ‘video blog’ here (also in Danish).

Here is an op-ed from the Danish Business Daily Børsen on the Chinese on the Chinese devaluations and why the talk of ‘currency war’ mostly is nonsense.

Finally here is an interview (in French) with Atlantico.fr about the risk of a repeat of the 1997 Asian crisis, My answer is yes, the Chinese situation is worrying, but the good news is that we have floating exchange rates across Asia rather than fixed exchange rates.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

The Chinese surprise devaluation yesterday and has put currencies across Asia further under pressure. This is only a natural and the most stupid thing local Asian central bankers could do would be to fight it. Rather as China moves closer to a freely floating exchange rate it should inspire other Asian countries to do the same thing and I am therefore happy to see that the Vietnamese central bank this morning has widened the fluctuation band for the Dong and in that sense moved a bit closer to a freely floating Dong. Even though the hand has been forced somewhat by the PBoC’s devaluation yesterday it is nonetheless positive that we are seeing a move towards more freely floating exchange rates in Asia.

In that since it is not a “currency war”, but rather a liberation war, which in the end hopefully will secure monetary sovereignty to Asian nations such as Vietnam.

The floating Renggit is a blessing – also when it drops

This morning we are also seeing big moves in the Malaysian Renggit and the Renggit has already been under some pressure recently on the back of a worsening of Malaysia’s terms-of-trade and increased political uncertainty.

The sell-off in the Renggit has sparked some local concerns and the demands for the central bank to “do something” to prop up the Renggit are surely on the rise. However, it is extremely important to remember that the problem for Malaysia is not that the Renggit is weakening. Rarther the Renggit-weakness is a symptom of the shocks that have hit the Malaysian economy – lower commodity prices (Malaysia is a commodity exporter), increased political uncertainty and Chinese growth concerns.

None of this is good news for the Malaysian economy, but the fact that this is reflected in the Renggit is not a problem. Rather it would be a massive problem if Malaysia today had had a fixed exchange rate regime has was the case during the Asian crisis in 1997.

So the Malaysian central bank (BNM) should be saluted for sticking to the floating exchange rate policy, which has served Malaysia very well for nearly exactly a decade.

In fact BNM should move even closer to a purely free float and waste no opportunity to stress again and again that the value of the Renggit is determined by market forces and that the BNM’s sole purpose of monetary policy is to ensure nominal stability. The BNM should of course observe exchange rate developments in the sense it gives useful information about the monetary stance, but never again should the BNM try to peg or quasi-peg the Renggit to a foreign currency. That would be the recipe for disaster. As would such stupid ideas as currency and capital controls.

My friend Hishamh over at the Economics Malaysia blog has an extremely good post on his take on the Renggit situation. You should really read all of it. The post not only tells you why the freely floating Renggit is the right thing for Malaysia, but it is also extremely good in terms of making you understand why every (ok most…) countries in Asia should move in the direction of the kind of currency regime that they have in Malaysia.

Here is a bit of Hishamh’s excellent comments:

Another week, another multi-year low for the Ringgit. Since BNM appears to have stopped intervening, the Ringgit has continued to weaken against the USD, to what appears to be everyone’s consternation. There is this feeling that BNM should do something, anything, to halt the slide – cue: rumours over another Ringgit peg and capital controls.

To me, this is all a bit silly. Why should BNM lift a finger? Both economic theory and the empirical evidence is very clear – in the wake of a terms of trade shock, the real exchange rate should depreciate, even if it overshoots. NOT doing so would create a situation where the currency would be fundamentally overvalued, and we would therefore be risking another 1997-98 style crisis. Note the direction of causality here – it isn’t the weakening of the exchange rate that gave rise to the crisis, but rather the avoidance of the adjustment.

Pegging the currency under these circumstances would be spectacularly stupid. I’ll have more to say about this in my next post.

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In the present circumstances, it’s not even clear why BNM should in fact intervene. You can make the argument that the Ringgit is fundamentally undervalued, and the FX market has overshot; but I have no idea why this is considered “bad”. If you want to live in a world of free capital flows, FX volatility is the price you pay.

… Malaysia’s latest numbers puts reserve cover at 7.6 months retained imports, and 1.1 times short term external debt, versus the international benchmark of 3 months and 1 times. Malaysia is at about par for the rest of the region, apart from outliers like Singapore and Japan.

Australia and France on the other hand, have just two months import cover, while the US, Canada and Germany keep just one month. You might argue that since these are advanced economies, there’s little concern over their international reserves. I would argue that that viewpoint is totally bogus. Debt defaults and currency crises were just as common in advanced economies under the Bretton Woods system. The lesson here is more about commitment to floating rather than the level of reserves. One can’t help but see the double standards involved here.

…All in all, this alarmism betrays a lack of general economic knowledge in Malaysia, even among people who should know better. Or maybe I’m being too harsh – it’s really a lack of knowledge of international macro and monetary economics.

…The Bank of Canada, the Reserve Bank of Australia, and the Reserve Bank of New Zealand, have all aggressively cut interest rates and talked down their own currencies – it’s the right thing to do in the face of a commodity price crash. BNM on the other hand has to walk and talk softly, softly, because Malaysians seem to think the Ringgit ought to defy economic laws.

Bravo! Please follow Hishamh! His blog posts are always good and insightful.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

This morning the People’s Bank of China (PBoC) cut its key policy rate by 25bp to 5.1% – undoubtedly reacting to worries about slowing growth. The question is whether such a cut is warranted or not?

I have long argued that over the long run 15% M1 growth has been consistent with nominal stability in China. Hence, from around 2000 to 2008 Chinese M1 stayed on a pretty narrow path around 15% yearly growth. In the PBoC reacted to the global shock and the expected negative shock to Chinese money-velocity by expanding money supply growth significantly pushing M1 way above the 15% trend – probably overdoing it quite a bit (and luckily so for the global economy)

However, since mid-2010 actual M1 has started to re-approach the old 15% trend and in 2014 actual M1 dropped below the 15% trend – indicating a tightening of monetary conditions. The graph below illustrates that.

Obviously one could easily argue that 15% M1 growth might be too excessive today as Chinese real GDP trend growth has slowed in recent years and will slow further in the coming years.

I would certainly agree with such argument. Therefore, I have tried to look at an alternative M1 trend where I assume the M1 growth should slow in line with a slowdown in potential real GDP growth from 10% (around 2010) to 6% in 2020. This basically means that I assume a gradual slowdown in “trend” M1 growth from 15% in 2010 to 11% in 2020.

The graph above also shows that (the green line). This trend (“Slowing trend growth”) is also still above the actual M1 level, but not by much. So in that sense today’s rate cut can be justified, but on the other hand based on such simple measures of the ‘money gap’ it is hard to argue for major monetary easing.

So what did I miss? Well, money-velocity. The calculations above assumes a stable trend in M1-velocity over time. That is probably wrong to do – particularly because the Chinese authorities are planing further financial sector liberalisation. But I will have to write about that at another time – now it is time to take the kids to the playground…